India resists Bernanke’s move to calm markets

Reserve Bank of India governor Y.V. Reddy showed remarkable restraint on Tuesday in not using interest rates to calm the volatile stock market.

He also dared to disappoint bond traders, many of whom were expecting at least a quarter percentage point reduction in the rate at which the monetary authority lends to banks overnight. After seven increases since October 2005, the so-called repurchase rate currently stands at 7.75%.

In explaining his decision to stand put, Reddy made as many as five references to the elevated pace of money supply in the economy. That makes the Indian monetary czar rather old-fashioned in a world where central bankers areso keen to write put options for the financial markets they have lost sight of the inflation risk their actions are helping to create.

“We can’t afford to drop our vigil on prices,” Reddy said on Tuesday at a press conference in Mumbai. The question is: How long will the US Federal Reserve allow him to hold his guard?

Capital flows may make it hard for the Indian central bank to keep its monetary policy autonomous of US pressures.

The arbitrage opportunity has widened in favour of moving funds into India where three-month money now earns five percentage points more than dollar deposits of similar maturity at global banks. That gap has almost doubledsince the Fed began cutting interest rates in September last year to restart credit markets frozen by the unravelling of subprime mortgages. And the interest rate differential can only widen if Fed chairman Ben Bernanke further pares the target for the overnight rate, as Fed Funds futures prices currently suggest.

Energy prices

Clearly, India will at some point have to begin trimming its own cost of borrowings so as not to be overwhelmed by overseas inflows. Before then, the authorities must complete the unfinished task of putting the inflation genie firmly back in the bottle. And that means pressing ahead with an increase in local fuel prices, which the government has delayed because of pressure from its political allies.

According to the calculations of Morgan Stanley energy analyst Vinay Jaising, the average price realization of petrol, diesel and other oil products in the Indian market corresponds with crude oil at $63 (Rs2,482) a barrel, a steep 30% discount to the current international level. This has kept the benchmark wholesale price inflation in India artificially suppressed at 3.8%. “In view of the new highs to which international crude prices have recently been lifted, the threats to domestic price stability have risen and turned extremely volatile, representing a serious risk to inflation expectations,” the Reserve Bank said in its monetary policy statement.

Slowing demand

And what about the risks to economic growth?

Sure, Indian exports in rupee terms have slowed down in recent months. That’s partly a result of faltering overseas demand and partly because of the 11% real, or inflation-adjusted, appreciation in the Indian currency in the past 12 months compared with India’s main trading partners.

Motorcycle demand has slackened because the interest cost on auto loans is now as high as 24% a year. Mortgage demand, too, is ebbing for the same reason. Reddy’s critics say these are signs that India’s red-hot consumer demand is cooling. But given that political tolerance for price gains in India is low—and elections are due in 2009—it makes sense for monetary policy to tackle inflation and leave the task of fighting the risk of economic stagnation to the government, which can easily do so in its annual budget on 28 February.

Money supply

Money supply is expanding at an annual 22% pace, higher than the Reserve Bank’s tolerance limit of 17.5%. This excessive growth is partly because banks have been a tad too active in mobilizing deposits, even raising funds at an effective cost of 9% a year and more.

Trouble is there’s ample liquidity in the banking system because of strong capital inflows and banks can, in fact, cut both lending and deposit rates without waiting for the monetary authority to prune its policy rate.

The Reserve Bank on Tuesday urged them to do just that. “Despite comfortable liquidity conditions, banks have not expanded credit proportionately,” it said.

If inflation expectations start coming off, it’s quite likely that banks will start paring their lending rates as early as next quarter. That may give the economy that grew 8.9% in the three months to September 2007 a chance to reaccelerate. Of course, a lot will depend on the health of the world economy and the risk appetite of global investors, on which capital flows into India—or out of it—will depend.

Pending the creation of new production capacity in the economy, the central bank is right in wanting to delay consumption to the extent it can. “We’ll be far more comfortable if more demand is generated later, than now,” Reddy said.

Those who support an immediate easing in interest rates say that this is a risky approach: Capacity expansion may stumble if consumers aren’t given a reprieve on mortgages and auto loans.

For now the evidence is on Reddy’s side. Controlling inflation has to be India’s priority even if that means sacrificing some growth. Bloomberg